Importance of the Wholesale Distribution

Tier in the California Cannabis Industry

Cannabis, whether medicinal or recreational, is a socially sensitive product subject to abuse that should be regulated and distributed responsibly. Governor Brown and the California legislature have shown understanding of the unique nature of cannabis by wisely enacting the Medical Cannabis Regulatory and Safety Act (“MCRSA”) to regulate the medical cannabis industry.

MCRSA emulates many aspects of the three-tier alcohol regulatory model used in California by implementing a wholesale/distribution tier that requires cultivators and manufacturers to use a distributor. This distributor is responsible for quality assurance, inspection and testing for purity and contaminants before the product can be delivered to dispensaries and eventually on to consumers. Governor Brown and the California legislature’s hope is that MCRSA will mirror the success of the three-tier alcohol regulatory system in California.

Over the last eight decades, this system has provided the public with a huge variety and selection of products, has fostered competition between suppliers, leading to innovation, superior quality and stabilized pricing and has assured efficient and effective regulation, control and taxation by the state.

Over 80 years ago, California, the federal government and a variety of other states implemented the three-tier alcohol regulatory system to eliminate the abuses generated by a practice known as a “tied-house” arrangement. The tied-house practice flourished in the post-prohibition era and involved large alcohol manufacturers directly owning or controlling alcohol retailers, bars and restaurants through contracts, agreements, bribes, pricing manipulation and/or threats to pull the product. Tied-hours manufacturers would often force and bribe retailers into engagement of aggressive and predatory marketing tactics designed to increase the use of products to possibly unsafe levels for consumers. By controlling the retailers, the manufacturers were able to implement monopolization and anti-competitive, predatory business and marketing practices that forced retailers to only sell the manufacturer’s products. By blocking other manufacturer’s products from being sold, the large manufacturers were able to manipulate and inflate the pricing of their own products.

The ultimate result of these tied-house arrangements was vertical integration and dominance over the market by one or two manufacturers. In order to combat this, California implemented a wholesaler/distributor tier between the manufacturer and the retailer. By eliminating tied-house arrangements, California’s alcohol industry now provides consumers with ready access to a selection of brands. The number and variety of alcohol brands in California substantially exceeds any other consumer goods industry brands. The new added tier ensures product purity and integrity. The result of the wholesaler/distributor tier system has been healthy monetary gains in taxes at the local, state and federal level, resulting in the world’s most reliable and cost effective system of revenue collection.

Although there are clear distinctions between cannabis and alcohol as a substance, the two industries have emerged from prohibition in similar ways and could pose the same potential dangers if not properly regulated. Fortunately, California has wisely recognized this threat and has implemented the same three-tier system that has worked well to regulate the alcohol industry. Rather than have the cultivator/manufacturer sell outright to the dispensary, a wholesaler/distributor is required to take the product from the cultivator/manufacturer and distribute the product to dispensaries accordingly. This is critical in ensuring: (A) efficient and effective regulation, control and taxation by the state, (B) public safety with regards to cannabis products and (C) an open, efficient and accessible market place for a multitude of cultivators/manufacturers and dispensaries while preventing monopolization and anti-competitive/predatory business and marketing practices.

In California, wine and spirits are distributed primarily by two distributors, while beer is distributed by approximately 65 distributors, including the two distributors for wine and spirits. This greatly decreases the state’s regulatory burden by limiting the number of distributors needed for monitoring. These distributors are simultaneously able to provide a majority of the information the state needs to regulate and tax the thousands of markets, liquor stores, bars and restaurants. As with alcohol regulation, the state can more easily regulate the cannabis market by having a small number of distributors who can efficiently cover all markets. Cannabis distributors will be the eyes and ears of the state, much like alcohol distributors are for the alcohol industry. The cannabis distributors will be responsible for tracking and tracing cannabis products as they travel from the cultivator/manufacturer to the dispensaries and reporting this information to the state. In addition, cannabis distributors will be responsible for coordinating and verifying independent third party laboratory testing of cannabis products to ensure their safety prior to being sold to the public by dispensaries. The state will be able to rely on the information provided by cannabis distributors to track quantities and types of products, as well as ensure product safety and accurate taxing on all levels. Moreover, since distribution is new to the cannabis industry, licensed distributors will be able to implement the most sophisticated track and trace technology currently used by big pharmaceutical companies to provide the state with real-time information on the industry.

The most important aspect of the state regulation of the cannabis industry is the assurance that cannabis products are safe for human consumption. Currently, there are no true safety standards for cannabis products like there are with alcohol. However, MCRSA requires state-licensed distributors to collect random batches of cultivator/manufacturer products and send the batches to independent, third-party laboratories. Distributors will record and report the results to the state, ultimately becoming the state’s agent in the effort to assure that cannabis is safe for human consumption. In order to uphold ultimate public safety, the state will need to be diligent when issuing licenses to ensure that professional and trustworthy companies are appointed to conduct this task. Moreover, the state must be meticulous when vetting the distributors to whom it grants licenses, as cities and counties will be motivated by the potential revenue generated by a licensed distributor operating in their location and may hand out too many permits without applying the level of scrutiny necessary.

As described in Section I, the three-tier alcohol distribution system plays a vital role in maintaining an open, efficient and accessible market place for alcohol that is free from monopolization and anti-competitive/predatory business and marketing practices. Cannabis distributors will also play a vital role in protecting and benefiting cultivators, manufacturers, dispensaries and consumers as explained below:

In the alcohol industry, distributors represent many different manufacturers and carry a variety of products to ensure that consumers have access to a large variety of products in their local markets. In fact, there has been seven percent (7%) increase in the sale of craft beer from small manufacturers throughout the United States in the last six years due to the ability of distributors to provide small manufacturers with a cost-effective method to get craft beer to markets that
wouldn’t be possible otherwise.

The importance of distribution will be especially true in the California cannabis industry, since cultivators/manufacturers will (1) be spread across the state, (2) be of varying sizes, (3) have varying financial resources and (4) be new to the mandatory distribution process. Although cultivators and manufacturers have expressed concern about the additional costs associated with adding a distribution tier, it is important to remember that cultivators and manufacturers
have their own costs of distribution already. These existing costs are not always easy to quantify for cultivators and manufacturers who may not factor in their own time and resources for building brand awareness, sales/introduction of new products, delivery/returns, customer service/personal follow up and track/trace. Distributors will provide California cultivators and manufacturers with the following benefits that will actually reduce cultivators and manufacturers costs and allow them to focus on their core competency:

• Product pick up from the cultivator/manufacturer;

• Testing and delivery to dispensaries;

• Sales representatives introducing and educating dispensaries on cultivator and manufacturer products and new lines; Provide expertise and economies of scale necessary to assist the building of competitive brands both regionally and statewide in a soon-to-be very competitive market;

• An avenue to markets that small and/or specialty cultivators and manufacturers would typically be unable to reach due to capital restrictions, lack of transportation, marketing and a sales force;

• Timely information to cultivators and manufacturers about local markets, trends, successes and failures so that suppliers can adjust accordingly;

• Protection of small and/or specialty cultivators and manufacturers from large, high-volume dispensaries that pressure cultivators and manufacturers into extremely low and unfair pricing leading to bankruptcy of small and/or specialty cultivators and manufacturers;

• Education to dispensaries and consumers about cultivators’ and manufacturers’ existing and new product lines;

• Deliver cultivator and manufacturer products on a regular and consistent basis to local dispensaries;

• Helping cultivators and manufacturers manage their production and budget for the future;

• Information related to changes in legislation, rules and regulations; and

• Protection from monopolization and anti-competitive and predatory business and marketing practices by large, wealthy cultivators and manufacturers.

A great example of this is a comparison of the potato chip industry two-tier model to that of the alcohol industry three-tier model. Grocery stores typically carry one to two different manufacturers’ brands of potato chips, the biggest being Frito-Lay. The reason is that a two-tier model is used in which Frito-Lay has its own distribution network in place and delivers directly to the stores. This allows Frito-Lay to effectively block other manufacturers and their products from entering the potato chip market and allows Frito-Lay to regulate pricing with virtually no competition.

In the alcohol industry, liquor stores, bars and restaurants depend heavily upon distributors, as will cannabis dispensaries, to provide the following:

• A wide variety of products at a reasonable and consistent cost; Ability to get information and order from the myriad of products that will be produced in the state from one sales person instead of multiple representatives. This leaves dispensaries time to focus on their business and their customers;

• Education about existing products and new product lines;

• Weekly product deliveries in manageable quantities to avoid both out of stocks and high inventories;

• Market insights and trends;

• Act as a communication conduit between the dispensary and the cultivators and manufacturers in order to provide product feedback;

• Give dispensaries displays and other sales materials that assist the dispensaries in selling product while educating consumers;

• Ensure dispensaries, both small and large, have consistent and competitive pricing to avoid anti-competitive and predatory practices; and

• Keep an appropriate level of inventory on hand providing the dispensaries with “just-in-time” delivery to minimize dispensary cash-flow and storage issues. This gives dispensaries adequate space to display a variety of products.

For example: there may be a specific strain of cannabis that aids in the treatment of epilepsy but is only manufactured by a small manufacturer in Northern California. This strain may not be an extremely popular strain for the general market but it is invaluable for those that need it. Most local dispensaries will not be able to bear the cost of buying and holding in inventory a specialized strain. Consequently, the only cost effective method of delivering this strain to each and every dispensary, especially in markets outside of Northern California, is going to be through a distributor who can afford to buy and hold the product in inventory.

Ultimately, all benefits of distribution for cultivators, manufacturers and dispensaries described in this document also benefit the consumer. Consumers will enjoy a huge variety and selection of products, confidence of availability and fostered competition between cultivators and manufacturers that leads to innovation, superior quality, safe products and stabilized pricing.

The importance of the wholesale/distribution tier to the California cannabis industry cannot be over-emphasized. As history has shown in the alcohol industry, without the wholesale/distribution tier, monopolization and anti-competitive/predatory business and marketing practices flourish. Implementation of the wholesale/distribution tier has led to huge varieties and selections of products and has fostered competition between suppliers leading to innovation, superior quality, safe products and stabilized pricing. This has ensured efficient and effective regulation, control and taxation by the state. Ultimately, what matters most is an open, efficient and accessible market place that provides the public with safe products at competitive prices. Governor Brown and the California legislature understand this and wisely implemented the distribution tier in MCRSA to ensure great progress for California.